Tuesday, April 05, 2011 12:03 AM

Fed Lending Increases Ultimate Cost of Bank Failures; 111 Banks Fed Lent Money to Failed

Via emergency lending mechanisms recently released data shows that 111 banks the fed tried to keep alive via emergency lending procedures ultimately failed.

Please consider the New York Times article Fed Help Kept Banks Afloat, Until It Didn’t http://www.nytimes.com/2011/04/05/busin ... ss&emc=rss

During the frenetic months of the financial crisis, the Federal Reserve stretched the limits of its legal authority by lending money to more than 100 banks that subsequently failed.

The loans through the so-called discount window transformed a little-used program for banks that run low on cash into a source of long-term financing for troubled institutions, some of which borrowed regularly from the Fed for more than a year.

The central bank took little risk in making the loans, protecting itself by demanding large amounts of collateral. But propping up failing banks can increase the eventual cleanup costs for the Federal Deposit Insurance Corporation because it keeps struggling banks afloat, allowing them to get even deeper in debt. It also can clog the arteries of the financial system, tying up money in banks that are no longer making new loans.

The discount window is a basic feature of the central bank’s original design, intended to mitigate bank runs and other cash squeezes. But access to it historically has been limited to healthy banks with short-term problems.

Those limits moved from custom to law in 1991, when Congress formally restricted the Fed’s ability to help failing banks. A Congressional investigation found that more than 300 banks that failed between 1985 and 1991 owed money to the Fed at the time of their failure. Critics said the Fed’s lending had increased the cost of those failures.

The central bank was chastened for a generation but in 2007, facing a new banking crisis, the Fed once again started to broaden access to the discount window. It reduced the cost of borrowing and started offering loans for longer terms of up to 30 days.

More than one thousand banks have taken advantage. A review of federal data, including records the Fed released last week, shows that at least 111 of those banks subsequently failed. Eight owed the Fed money on the day they failed, including Washington Mutual, the largest failed bank in American history.

Charles Calomiris, a finance professor at Columbia University who has studied discount window lending during previous crises, said the Fed had not released enough information for the public to determine whether some of the recipients were propped up inappropriately and should have been allowed to fail more quickly.

Marvin Goodfriend, a professor of economics at Carnegie Mellon University, said that such lending placed the Fed in the inappropriate position of deciding the fate of individual banks, choices that he said should be made by elected officials.

“What I think is the lesson from this is that the Congress needs to clarify the boundaries of independent Fed credit policy,